1. U6018 CLASS NOTES
International Money Finance Notes
Lecture Notes
The FOREIGN EXCHANGE Market

2. Some Basic Facts
5 Trillion dollars a day - the world's largest asset market
Interbank Market
Transaction are Spot, Forward, and Swap
Central Banks/Sovereign Wealth managers are Players

3. Simple Schematic Diagram of FX Market
Fed
ECB
SAFE
Citi
direct DB
Broker
Audi
Wal Mart
Simple Schematic Diagram of FX Market

4. Foreign Exchange Market Setting
Direct Dealing and Brokers
Retail and Market maker Counterparties

5. A 5 Trillion Dollar a Day Market

6. USD is Leading Vehicle Currency – is on 88 percent of all FX Trades

8. Dollar is Still Leading Global Reserve Currency, but Share is Declining

14. Market Dominated by London and New York
In each Triennial survey since 2001

16. 2016 New York Fed Survey

21. Forwards are small part of market, Instead Foreign Exchange Swaps
In recent years daily swaps volume has been more than 4 times greater than daily forward volume
Swaps bundle a spot and forward transaction
Spot purchase (sale) and forward sale (purchase) of equal amount of foreign exchange. The embedded rate in the transaction is the swap rate which is closely linked to the forward rate.
Vehicle currencies - the emergence of the Euro
Most foreign exchange transactions have the dollar on one side
Even if ultimate goal is to exchange one non-dollar currency for another

22. Triangular Arbitrage and the Vehicle Currency
The CAD/EUR exchange rate (a small illiquid market) is pinned down by the CAD/USD and USD/EUR markets which are much more liquid by TRIANGULAR ARBITRAGE.
CAD/EUR = (USD/EUR)(CAD/USD)
= times
Suppose this did not hold with CAD/EUR at 1.49
USD/EURO > (CAD/EUR)/(CAD/USD)
Then Take 100 USD and buy CAD. Take these CAD and buy /1.49 EUR. Take these Eur and sell them for (138.92/1.49) dollars.
You end up (1 second later) with $ That’s $1.02 bps of profit a second with no risk. $838 of profit per minute (and 83.8 % return!) a minute. $2,221,1858 of profit a day a day. At no risk. So why stop at $100? How bout a billion? All day. Thus triangular arbitrage must hold. And it does.

23. Triangular Arbitrage at Work

24. Ask-Bid Spread: What is it?
Market makers want to make money (and not to hold on to foreign currency).
They charge a spread between the price they buy foreign exchange and the price they sell
Spread on interbank transactions is incredibly small and much less than daily swings in the currency.
A market maker who is unlucky enough to get long foreign currency at the intraday high price and unwind and the intraday low will lose a lot of money, and the ask bid spread will not be enough to make it up!

25. Bid – Ask Spreads are Exceedingly Narrow Relative to Daily Swings
For example, on September 25th, spread on Euro at 7:01 am ranged from .0002/ to .0001/
Note that the spread is miniscule compared with the daily high - low which was = .0092
Also note that at any given minute there is some variation across dealers in their quotes

26. Bid Ask Spreads and Volatility
In periods of volatility spikes, bid ask spreads have in the past risen as dealers take on more inventory risk to make the market
However, this has not happened so much in recent years

27. U6018 CLASS NOTES
FOREIGN EXCHANGE OPTIONS AND FORWARDS

28. A Forward Contract
If I think the USD is going to depreciate over the next 90 days against GBP relative to the forward
Eet+90 > Ft,90
Then think I will earn an expected positive risk premium by being long the pound. I can enter into today a forward contract to receive GBP and deliver USD with a counterparty at a specificed date in the future. No money changes hands today. Since I am buying GBP forward, I can’t ‘pick’ the forward rate. The forward rate is what it is by CIP. A forward contract obligates me to buy a pre specified amount of GBP at a specificed price - the forward rate - agreed today for exchange at a specified date in the future.
USD Cash Flow at Expiration from Long 100,000 GBP 90 day Forward
[Et+90 – Ft,90]100,000
USD Cash Flow at Expiration from Short 100,000 GBP 90 day Forward
[Ft,90 – Et+90]100,000

29. USD Cash Flow on Long Forward Position
USD CASH FLOW AT time T Expiration of a forward contract as a function of the spot rate at time T
Max profit unlimited
Per Unit of Notional foreign exposure
Slope = 1 ET F
Max loss = -F

30. Example
If I buy 100,000 GBP forward, my cash outflow on January 2 is 0. I’m obligated on April 3rd to deliver 195,190 dollars and receive 100,000 GBP.
On April 3, it turns out that the spot exchange rate is I can thus sell the 100,000 GBP for 197,410 dollars for a profit of times 100,000 at expiration. Thus in this example, speculating with a forward is ex post profitable. But this will not be the case when the dollar appreciates relative to the forward.

31. USD Cash Flow on Long Forward Position
USD CASH FLOW AT time T Expiration of a forward contract as a function of the spot rate at time T
Max profit unlimited
Per Unit of Notional foreign exposure
Slope = 1
Profit = per GBP notional ET
F=1.9519
ET =1.9741
Max loss = -F

32. Betting on a Strong Dollar
If I think the USD is going to appreciate over the next 90 days against EUR relative to the forward
Eet+90 < Ft,90
Then think I will earn an expected positive risk premium by being short the Euro. I can enter into today a forward contract to deliver Eur and receive USD with a counterparty at a specificed date in the future. No money changes hands today. Since I am selling Eur forward, I can’t ‘pick’ the forward rate. The forward rate is what it is by CIP. A forward contract obligates me to sell a pre specified amount of Eur at a specificed price - the forward rate - agreed today for exchange at a specified date in the future.
USD Cash Flow at Expiration from Short 100,000 Eur 90 day Forward
[Ft,90 – Et+90]100,000
Note that in this case I am receiving Ft,90∙100,000 dollars from counterparty but it will cost me Et+90∙100,000 dollars to obtain the 100,000 I am obligated to deliver. In effect, I am borrowing in Euros to fund a USD investment so a forward contract is ex ante risky unless it is offset with another position.

33. USD Cash Flow on Short Forward Position
USD CASH FLOW AT time T Expiration of a forward contract as a function of the spot rate at time T
Max gain = F
Slope = -1
Per Unit of Notional foreign exposure ET F
Max loss = unlimited

34. Foreign Exchange Call Options
Currency Call Option gives the buyer of the option contract
the right -but not the obligation -to buy a specified quantity of
foreign (home) currency at a specified price -the strike rice -at a specified date in the future - the expiration date.
The price of the call option is paid up front (not on the expiration date). It is useful to think of the option buyer as borrowing funds to pay the option premium today.
A Call Option has value at the expiration date T if the Spot
exchange rate exceeds the strike price on that date. For example, if I hold a call option at expiration it is worth
Value of Call at expiration date T = max[0, ET – Estrike]]
A call option makes the buyer long the foreign currency (if exercised) and gains value if foreign currency appreciates relative to home money.
Example: A call option on 100,000 GBP with strike price equal to 1.95 that expired on June 2, 2007 when spot GBP was 1.97 was worth
max[0, ET – E strike]100,000 = [1.97 – 1.95]100,000 = $2000

35. Payoff at Expiration of a Call Option on Foreign Currency
CASH FLOW AT T = Expiration
A call option expires in the money whenever ET > E strike
Per Unit of Notional foreign exposure
Slope = 1 ET
E strike
E strike+ P call(1 + R) is break even level for spot at expiration
-PCALL(1 + R)
Note that the price of the option is paid up front not at expiration , but to compare forwards to options , it is useful to think of borrowing the money to pay for the option and paying off the loan with the proceeds for cash flow at expiration (if there are any).

36. Cash Flow on Call Option Struck ATMF versus Forward
CASH FLOW AT T = Expiration
Per Unit of Notional foreign exposure
Slopes = 1 ET F
E strike = F
-PCALL(1 + R) -F

37. Speculating with a Call Option
If I think the USD is going to depreciate against GBP, I can buy a call option on GBP. Since I am buying the call (I am ‘long’ the call) I can pick my strike price.
The further away is the strike from the current spot, the cheaper is the call option, but the less likely it is that the call expires in the money.
For ease of comparison, I price a GBP 90 day call with a strike equal to the forward exchange rate. This is said to be ATMF (at the money forward) and is the most liquid strike in the OTC options market.
Cash Flow at Expiration from Long GBP Call
Max [ET – Estrike, 0]100,000 – Pcall(1 + Rt,90)100,000

38. Example
As on January 2, 2007 the strike price on a 90 day ATMF GBP call was The $ price of the 90 day ATMF call on January 2 was If I bought 100,000 GBP calls, my cash outflow on January 2 was $2, It is useful to think of financing this cash outflow on January 2 with a loan financed at LIBOR.
On April 3, the spot exchange rate was GBP = My option was worth = at expiration. But the price of the option was and I accrued interest liability of this amount. Thus even though the option was ‘in the money’ it did not cover the cost of the option.

39. Betting on a Weaker USD – ATMF Long GBP Calls versus Forwards
CASH FLOW AT T = Expiration, April 3,2007, per pound E F ET
-PCALL(1 + R)
1.9741
(1.0134)
1.9519

40. Foreign Exchange Put Options
European Currency Put Option gives the buyer of the option contract
the right - but not the obligation – to sell a specified quantity of
foreign currency at a specified price - the strike rice - at a specified date in tile future - the expiration date.
The price of the put option is paid up front (not on the expiration date). It is useful to think of the option buyer as borrowing funds to pay the option premium today.
A Put Option has value at the expiration date T if the Spot
exchange rate falls short of the strike price on that date. For example, if I hold a put option at expiration it is worth
Value of Put at expiration date T = max[0, Estrike] - ET]
A Put option makes the buyer short the foreign currency (if exercised) and gains value if foreign currency depreciates relative to home money.
Example: A put option on 100,000 EUR with strike price equal to 1.30 that expired on June 2, 2007 when spot EUR was 1.35 was worthless
max[0, Estrike - ET]100,000 = max[0,1.30 – 1.35]100,000 = $0

41. Cash Flow at Expiration of a Put Option per unit of Notional
CASH FLOW AT T ET
strike
-Pput(1 + R)

42. Speculating with a Put Option
If I think the USD is going to appreciate against EUR, I can buy a put option on EUR. Since I am buying the put (I am ‘long’ the put) I can pick my strike price.
The further away is the strike from the current spot, the cheaper is the put option, but the less likely it is that the put expires in the money.
For ease of comparison, I price a EUR 90 day put with a strike equal to the forward exchange rate. This is said to be ATMF (at the money forward) and is the most liquid strike in the OTC options market.
Cash Flow at Expiration from Long EUR Put
Max [Estrike - ET, 0]100,000 – Pput(1 + Rt,90)100,000

43. Example
As on January 9, 2012 the strike price on a 90 day ATMF EUR put was The price of the 90 day ATMF put on January 9 was If I bought 100,000 EUR puts, my cash outflow on January 9 was 3357 dollars. It is useful to think of financing this cash outflow on January 9 with a loan financed at LIBOR.
On April 9, the spot exchange rate was EUR = My option was worthless at expiration. I also pay off my loan at expiration.

44. Speculating with a Forward Contract
If I think the USD is going to appreciate against EUR relative to forwards
Eet+1 < Ft,1
I expect to earn a risk premium by being short the GBP and borrowing in pounds to invest is US bonds. Note that even though I am investing in US bonds, this is risky because a forward contract is equivalent to borrowing in foreign currency
I can sell EUR forward. Since I am selling EUR forward, I can’t ‘pick’ the forward rate. The forward rate is what it is by CIP. Unlike an option, a forward contract obligates me to sell EUR at the forward rate agreed today for execution in 90 days.
If I sold 100,000 EUR forward, my cash flow on January 9 was 0.
On April 9, the spot exchange rate was EUR = My position was underwater by an amount equal to [ – ]100,000
Cash Flow at Expiration from short EUR Forward
[Ft,90 – ET]100,000

45. Betting on a Weaker EUR – ATMF Long EUR Puts vs. Forwards
CASH FLOW AT April 09, 2012 per Euro
1.3206 F ET
-Pput(1 + R)
1.2774
(1.0014)